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The most significant reason index funds lag their benchmarks is the impact of management fees and GST/HST. If your index fund has an MER of 0.25%, you should expect its tracking error to be within a basis point or two of that figure. But it’s often more than that—and sometimes it’s much less. In a series of two posts this week, I’ll look at some real examples from 2012 to illustrate the other factors that can cause an ETF’s returns to vary.

Currency hedging. US and international equity ETFs hedge currency risk using futures contracts. These are renewed every month, and if there’s a dramatic currency movement between contracts—or if the fund experiences a large cash inflow or outflow—that can show up as tracking error. The iShares S&P 500 (XSP) and Vanguard MSCI U.S. Broad Market (VUS) both had tracking errors over 70 basis points in 2012, despite MERs of just 0.24% and 0.17%, respectively.

Currency hedging can also work in the fund’s favour, however. That may help explain why both the iShares MSCI EAFE (XIN) and the Vanguard MSCI EAFE (VEF) outperformed their benchmark last year—indeed, XIN did so by 47 basis points. That was a lucky accident: over the long term one should expect currency hedging to cause a drag on returns because of its significant cost.

Cash drag. Most mutual funds keep cash on hand to pay investors who redeem their units. ETFs typically don’t do this, because their structure allows them to make redemptions without selling securities. But some ETFs may keep extra cash on hand, and this can lead to tracking error.

The BMO Equal Weight REITs (ZRE) trailed its benchmark by 76 basis points last year despite an MER of 0.62%. According to the fund’s annual report: “A small portion of cash was held within the portfolio to accommodate distributions. This portion of the portfolio can cause a drag on positive returns because the ETF was not fully invested. The underperformance caused by the ETF’s cash holdings was 0.14%.”

Poor sampling. Most equity ETFs hold every stock in their benchmark, even if there are thousands of them. It’s dangerous to do otherwise: several years ago, some of the old Claymore ETFs held only a representative sample of the stocks in their US and international funds and they got clobbered with enormous tracking errors.

But broad bond index funds can never do this: the major DEX indexes are enormous, and they include illiquid bonds the fund couldn’t buy even if it wanted to. These funds have no choice but to use sampling: they buy a smaller number of bonds that approximate the overall characteristics of the index (average term, coupon, duration, etc.).

You’re likely to see the biggest sampling errors with corporate bond funds. The iShares DEX All Corporate Bond (XCB) did quite well in 2012 with a tracking error of 52 basis points and an MER of 0.44%. However, since its inception in November 2006 its tracking error has been over 80 basis points.

Securities lending. A number of index funds engage in securities lending: that is, they lend stocks and bonds to short-sellers to earn extra revenue. While some critics consider this risky, when done responsibly it can actually benefit investors by offsetting some of the fund’s management fees. Normally these revenues are very small, although the iShares S&P/TSX 60 (XIU) earned almost $3 million from securities lending in 2012.

Typically funds keep some of these profits for themselves and pass along a portion to investors. (Vanguard is the exception in giving all securities lending revenue to unitholders.) In my opinion, any index fund that keeps revenue from securities lending should first ensure its tracking error is no higher than its management fee. Unfortunately, XIU lagged its benchmark by 20 basis points in 2012 even though it’s MER is just 0.18%.

Later this week I’ll look at other factors that may affect how closely an ETF tracks its benchmark index.

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